Bitcoin: What you need to know
You’ve probably heard something about Bitcoin. What you’ve heard depends greatly on who you are and what circles you’re in.
Most people have probably heard the name but don’t really know what it is beyond that it’s some kind of internet thing that either people seem to be making a lot of money with or alternatively losing a lot of money with. Oh, and maybe that it’s that currency that you can use to buy drugs from the internet and one guy got arrested running some site like that a couple of years ago.
Those of you who spend more time around financial discussions are likely to think of it like a stock or bond, but somehow with no company or tangible asset such as a precious metal to give it any ‘real’ value.
And those of you who are classic computer geeks and crypto nerds have probably recognised it as a really fascinating practical implementation of proof of work and creation of uniqueness in the digital world where things are otherwise so easily copied, and maybe even support the idea of a digital currency, but don’t really understand where the value aspect comes in to play or how.
In a way, each of these understandings is correct in its own way but none of them are a full picture and therefore each of them will work on false assumptions about what bitcoin is, what bitcoin is not, and what expectations should be held.
Therefore, this article attempts to explain both what bitcoin truly is and clear up some misconceptions around this technology.
Bitcoin is a digital currency, specifically a cryptocurrency. It has properties that resemble cash, other properties that resemble precious metals such as gold, and yet other properties that are unique to cryptocurrencies.
It is typically written as BTC however the standard from ISO – the International Standards Organisation – is XBT (‘X’ implying a currency or store of value that is not bound to a specific country, just as Gold is written as XAU when dealt with as a commodity).
Once upon a time – in the far reaches of history (actually, just over 8 years ago) – there were no bitcoins. A mysterious figure (or perhaps group of people claiming to be an individual) going by the name of Satoshi Nakamoto devised the initial concept of bitcoin and began creating virtual coins. He shared this idea with others over the internet and they too began creating more coins. As more coins got created and more people began to share the idea – and importantly trade coins with one another –Nakamoto quietly disappeared and has not been heard of since. Nobody knows who he was, but we know that the many coins he created (around 1 million) have not been moved out of his virtual wallet. In fact, no one can even say for sure if he’s still alive or if he has access to those coins or not. Since then however, bitcoins value has changed from a fraction of a cent per coin to hundreds of dollars per coin, making anyone with access to those coins a multimillionaire.
Looking at this paragraph, someone with no knowledge of how bitcoin works must be incredulous at this stage. How can coins be worth so much if someone can create millions of them so quickly out of nothing? Well, the answer is that coin creation gets harder as time goes on. Creating new bitcoins is done with a process called mining. This process is a series of mathematical hashing algorithms applied to transactions that have happened on the network. That is, when I send you some bitcoin, it isn’t confirmed until someone has applied the necessary algorithms and written it to the public ledger. Of course, not only one transaction is confirmed at a time, but rather many transactions at once in a block.
This public ledger is called the blockchain (because it’s a chain of blocks). It is shared across the entire network and anyone can examine it to see what it contains.
The algorithms that are used for mining are not actually complex, but they are computationally expensive (require a lot of processor time). The difficulty of the algorithm can also be changed as needed and the bitcoin protocol defines how difficult new blocks are to mine. This results in a new block being processed approximately once every ten minutes regardless of how many new miners join and how much computing power increases over time.
The public and distributed nature of the blockchain is a critical aspect of bitcoin. If it were centralised instead, there would be no way to know that someone hadn’t cheated and altered the ledger incorrectly. As it is, anyone attempting to change the ledger will simply now have a different version of it to everyone else and will be rejected by the network as being incorrect.
This means that in order to ‘fake’ bitcoin, you would need to get the vast majority of miners in the world to all agree to do it simultaneously, and somehow re-compute all of the previous transactions with your changes intact in the space of time it takes before new blocks are added (again, around 10 minutes). The first half is practically impossible and the second half is provably impossible mathematically regardless of how much computing power you throw at it.
Not only does mining get more difficult, it also produces less coins over time. At the beginning of bitcoin, mining a block would reward you with 50 bitcoins. Every four years, an event called the “bitcoin reward halving” or more colloquially, “the halvening” takes place. There have been two halvenings since bitcoin started, so a block reward is now 12.5 bitcoins.
As time goes on, there obviously becomes less direct incentive to mine for bitcoin. This is solved in two ways. The first is a direct manner – bitcoin transfers have an optional fee. They are theoretically optional, but without including one your transaction will never be confirmed and so for all practical senses, it must be included. Miners will choose to mine those blocks with the highest fees attached first, so the higher the fee, the faster you’ll get confirmed. In reality, this value is very small however and doesn’t scale with the size of the bitcoin transfer, so whether I’m sending you five dollars worth or five million dollars worth of bitcoin, the fee will be the same. It does scale slightly with some other technical factors, but these aren’t relevant for a typical user so I won’t go in to detail here.
If you’re paying attention, you’ll realise that over time, there will also be less and less new bitcoin available, since the only way for bitcoin to be created is mining, the time-span it takes to mine is relatively fixed, and the amount of coin created gets reduced. This is a deliberate feature of bitcoin. In fact, one day there will be no new bitcoin created by mining at all – miners will get all of their money from fees. The maximum bitcoin that can ever exist is 21000000 (twenty-one million).
This leads to the second way that miners are incentivised to continue. Something that has increasing or steady demand but decreasing supply is by its very nature a deflationary system. Unlike traditional currencies where the value of the currency is inflationary, bitcoins naturally increase in value over time.
Here is where the economists and financial analysts jump in and start screaming about how this can never possibly work. It’s common wisdom in the financial world that a small amount inflation is necessary to spur economic growth. If you don’t have at least some inflation (or especially if you have deflation), people just hold on to their money instead of spending it and therefore the economy stagnates.
This isn’t wrong, but it makes the false assumption that bitcoin is a traditional currency playing by traditional rules. Until bitcoin grows significantly, it is naturally very volatile. Single large traders can swing the value of bitcoin (compared to local fiat currencies) up and down much more than more heavily traded commodities and currencies. Because of this, no one currently denominates values of things in bitcoin directly, but always as a bitcoin value of a local fiat currency. That is, right now, I’d never expect a car sales person to offer a new car for 60BTC, but instead €50000, which I could choose to pay in bitcoin by giving him 58.578BTC (at today’s exchange rates – tomorrow it could be 40, 50, 60, 70, or something else entirely).
It’s worth noting here in case it wasn’t already obvious though that bitcoin is divisible. 58.578BTC is a perfectly valid number. In fact, bitcoin is technically infinitely divisible. Right now, the smallest agreed unit (the “satoshi”, named for the creator) is 0.00000001 BTC – that is, a hundred millionth of a bitcoin – but if necessary, it can be divided further. There is a growing trend in fact to talk about bitcoin values in mBTC (milli-bitcoins or 0.001 bitcoins) rather than bitcoins directly, since one mBTC is hovering around the value of a US dollar (actually around 90 US cents as I write this) and therefore a much more ‘approachable’ number in terms of what people are comfortable with.
As bitcoin is not used as a direct value in trade yet (due to the volatility), the deflationary nature does not impact its use. Many people do choose to hold a value of bitcoin, but they are also happy to spend it and then (optionally, but typically) replenish their values from fiat as doing so has no negatives over using the fiat and can have many significant positives.
The less sophisticated financial analysts and economists may at this point of the discussion choose to argue that this volatility is inherent in a system like bitcoin not because of the low usage, but in fact because it has no intrinsic value; that is, unlike gold which can be used for industrial purposes, jewellery, and so on, bitcoins are purely virtual and therefore are only worth what people think they’re worth.
I bring this argument up not because it has great merit, but because it’s depressingly common. It’s wrong on many levels. The first is that fiat currency also typically has no intrinsic value either. Once upon a time many currencies were backed by gold or silver, but every major currency is now floated and is unbacked. The intrinsic value of the paper or metals in the coins is so low as to be meaningless really. Fiat currencies work fine without intrinsic value, so bitcoin could as well. The second and more glaring point is that bitcoin does in fact have intrinsic value! That value is in the blockchain technology I mentioned earlier. What is the value of being able to – without a doubt – prove that a certain event occurred at a certain time? That’s exactly what the blockchain does. Messages can be written in to the blockchain along with transactions and thus the intrinsic value of a bitcoin transaction is the value of an immutable, permanent, and trustworthy (without requiring trust in any individual or group) record of an event. What this is in monetary terms is also arguable, but it’s certainly significantly more than the value of a piece of printed paper or a few grams of a reasonably common metal.
That said, I don’t actually consider this to have much bearing on the value of bitcoin over time, simply something that can set a lower bound on the value. This is identical in concept to fiat in that the lower bound of the value of a euro or dollar coin is what you get when you melt it down as metal, but if it ever actually drops to that level you have a lot more to worry about than selling scrap metal.
So far I’ve described how bitcoins are created, how the blockchain records their existence and transactions, and some points about their value; but how do you actually get them, store them, and spend them?
The first thing you need is a wallet. This isn’t actually anything like the fake-leather billfold you have in your pocket or purse, but has the same purpose conceptually; that is, storing your money. Wallets on the technical level aren’t quite what most users expect. It’s common usage for someone to say that they have a certain amount of bitcoins in their wallet, but the truth is that bitcoin wallets don’t actually store any bitcoin at all!
Bitcoins aren’t like specific files that are stored somewhere at all. They only exist as a description of their creation and transactions within the blockchain. Therefore – from one perspective – all bitcoins exist on all computers that are holding a copy of the blockchain. That doesn’t actually matter though, since – as mentioned earlier – you can’t cheat and manipulate the blockchain because your copy would no longer match everyone else’s and would be rejected.
So, if the coins are in the blockchain and not in the wallet, what is the wallet? The wallet is an implementation of a public key infrastructure (PKI) key store. That might sound complicated, but it’s actually beautifully simple and is the same technology used for thousands of other tasks such as ensuring secure connections to websites like LinkedIn, encrypting email communication, and authenticating yourself with smart cards or your mobile phone. You have two pieces of digital data called your public key and your private key. Really, they’re just numbers that can be used in equations. The public key can be determined from the private key, but not vice versa. Encrypting something with the public key can only be decrypted by the private key. Also, something can be signed with the private key and the public key can be used to prove that it was indeed signed by that key. This means you keep your private key to yourself and give your public key out to anyone at all.
The easiest way to consider this is the case of email. If I want to send you an email that only you can read, I get your public key (which you make as publicly available as you can, such as putting it on a website or an open database of public keys) and encrypt the message using it. Now that encrypted message can pass through a hundred computer systems and no one can read it because they don’t have the private key that decrypts the message. Once you get it, you decrypt it with your private key, and can read the message. You can then reply using my public key to encrypt, ensuring that only I can read your reply no matter how many people it passes through.
Because your public key is – by definition – public though, you might also want to ensure that you know it really is me that is sending you the email and not someone pretending to be me. Therefore, aside from only encrypting the message with your public key, I also sign it with my private key. Once you receive it and decrypt it with your private key, you can also use my public key to verify the signature is valid. Now you know that not only has no one else read the message, but also that it definitely came from me (or at least, someone who has my private key – you still need to trust that I kept that secret).
Getting back to bitcoin now: In terms of a bitcoin wallet, this exact same concept is used. Your wallet holds the keys and therefore proves you are the owner of the coins mentioned in the blockchain as well as ensuring that you are the only person who can send them to someone else. This also means that your wallet can be an unchanging entity. Since the wallet itself doesn’t get updated each time a transaction takes place – there is no data being written to the wallet file – you can store it in a variety of different ways.
The most common wallets are desktop computer and mobile phone wallets. The bitcoin core software is the reference implementation and the first wallet to exist. By design, it keeps a full copy of the blockchain however and is therefore quite large (and slow to synchronise the first time you start it), so is not recommended for beginners. The Electrum wallet would be my recommendation for a popular and simple desktop wallet, and I personally like BreadWallet for my iPhone. There are several others, but always be sure to do a little checking with Google first to ensure that it’s a known trustworthy wallet. It’s not technically hard to write a piece of software that acts like a wallet until one day it just steals all your bitcoin and sends it to someone else.
Another way that people store bitcoin is online. I can not advise against this strongly enough. There are many exchanges online where you can purchase bitcoins and these will also store your coins for you, making it easy to buy and sell at leisure; however, this is essentially trusting an unregulated bank to hold your money for you. There have been several high-profile hacks of online bitcoin exchanges (often incorrectly reported as bitcoin itself being hacked; but – as explained earlier – that is mathematically impossible) where people have lost huge amounts of bitcoins. If you don’t hold the keys to your coins, you don’t own your coins.
Here is where I know some of you are feeling a bit nervous. You want to get bitcoins, and I just told you not to trust online systems, but you also don’t really trust your computer. You’ve had viruses before and sometimes you make mistakes and delete things that you didn’t mean to. What if you’ve got hundreds of dollars in bitcoin and you accidentally delete your wallet so you can no longer access them? Or what if a piece of malware steals your wallet?
This is where the beauty of the simplicity of wallets comes in to play. They don’t have to even be on a computer! Digital currency doesn’t mean you have to store everything on a computer. There are two options for non-computer wallets: Paper Wallets and Hardware Wallets.
Hardware Wallets feel a bit more computer-like and are easy to work with, but they will cost some money (I own a Ledger Nano S, which retails for around €70, however I paid in BTC of course). They are physical devices that you connect to your computer to make transfers on and off the wallet, but the key itself can not be read from the device, nor can a new one be written to the device, and transactions must be confirmed on the device’s own screen, so even if a piece of malware faked what is shown on the computer, it can’t steal anything since you would deny the confirmation prompt on the hardware wallet when it tried.
Paper Wallets are yet another step removed in that it really is just a piece of paper with the cryptographic data written (or encoded in something like a QR code) on it. Using it can be more cumbersome since you need to either enter the data on your computer to make transactions and then destroy the old paper wallet (since it’s no longer truly secure after you’ve done that) and create a new one each time which you transfer your balance to; or conduct all of your transactions offline (either a completely offline computer, or if you’re feeling up to it, pen, paper, and optional calculator) and then only transmit the transaction itself to the internet from a computer. They do however make excellent long term storage of your coins.
For typical daily or ad-hoc use, neither of these are completely practical. Of course, there is nothing stopping you having more than one wallet. Personally, I keep the bulk of my bitcoin on my hardware wallet and a small amount on BreadWallet on my iPhone. If I ever need to (but I haven’t yet), I can transfer from my hardware wallet to my phone easily enough when I’ve got both with me and am in front of my computer.
Modern desktop and mobile wallets also do have back-up functionality in case of data loss. It won’t prevent malware from stealing money out of the wallet (so always keep your virus checker up to date and your wallet balance not too high) but it at least protects against accidental deletion or other such issues. Because the private key can be represented in many ways, the most common way that these programs allow you to keep a backup is by writing a series of words down on a piece of paper and storing it somewhere secure. These words are a recovery phrase that allows the software to regenerate your key should you ever need to. Note that hardware wallets also typically have this functionality, so should my Ledger Nano S ever get lost, stolen, or destroyed, I can buy a new one and get access to my coins again by entering the secret passphrase (which I’ve of course stored securely separately to the device).
Given that only twenty-one million bitcoin can ever possibly exist, there are really only two possibilities for the value of bitcoin in the long term. Dropping to near zero as everyone decides it is a pointless experiment and has no value, or increasing to the point that one bitcoin is worth one twenty-one-millionth of the economy that it covers. Assuming that it does not drop to near zero, we should then try to determine what kind of economy bitcoin could cover in the future.
Hopefully it should be clear from the description thus far that there are currently two main obvious ‘uses’ of bitcoin. Speculative trading – trying to predict the volatility to buy when it’s low and sell when it’s high – and as a long term investment due to the continuous upward trend despite the volatility.
There is one view however that – while less common – is important from a philosophical standpoint. That is that the true value of one bitcoin is: one bitcoin. That is to say, when bitcoin is finally ‘mature’, it will no longer be necessary to consider it in terms of its value in euro, dollars, yuan, or any other national/multinational currency but instead as a value in and of itself. Once there are sufficient users, the volatility should drop to a similar level or lower than other currencies and you will no more consider the value of it in a fiat currency in the same way that no one in Germany really cares about how much their groceries cost them in terms of US dollars and no one in the US really cares about how much their groceries cost them in terms of the euro. The exchange rates do still exist and have meaning, but the other currency is not a meaningful factor in daily life.
Aside from the obvious uses, bitcoin is seeing significant use for two other purposes. The first – and perhaps smallest, but growing use – is direct purchasing of goods and services. Aside from the somewhat well-known illegal dark net markets, there are surprisingly many places that bitcoin can now be used directly to purchase goods and services online. In Hannover, Germany (where I live), the local power/utilities company accepts bitcoin. You can purchase meal replacements with it. You can use a shopping proxy to get discounts from Amazon (not all regions of the world). And many many more. If you really want to, you can even get bitcoin backed debit cards and use them anywhere you’d use a card normally; however, the practical point of this is still limited at the moment.
The other use is perhaps one of the most interesting: international money transfer. Transferring money internationally is an expensive and slow proposition. Most banks and other institutions will give poor exchange rates on top of the fees in order to maximise their profits even further. Further complicating things is that in many parts of the developing world, there are significant people that do not have bank accounts (but do have mobile phones – especially in Africa), and in many other parts there are strict controls on the transfer of money in and out of the country. Yet more complications arise in tax codes when paying contractors or suppliers internationally. By using bitcoin as a medium of international money transfer, virtually any amount of money can be sent anywhere in a matter of minutes with only a few cents of transfer fees and generally well under 1% in exchange fees (depending on location).
This itself has many sub-uses, such as: avoiding the hyperinflation when dealing with Venezuela; paying suppliers in other countries quickly and efficiently; sending money to family members overseas; and much more.
Am I suggesting you buy some bitcoin? To be honest, yes, yes I am. As any rational person would tell you, never put in more than you are comfortable losing completely. If the loss of $50 would mean you’re in trouble, don’t buy $50 worth of bitcoin. But maybe you can afford $5? $1?
Or maybe you could buy more. Maybe you often go out on weekends and hand out $100 on taxis, drinks and door fees throughout the night. Perhaps skipping one weekend and putting that $100 in to bitcoin is something worth considering. A common myth is that because bitcoin is “expensive”, it’s now too late and all the big gains are gone. Something to remember is that people were saying this when bitcoin reached parity with the US dollar, that is when 1BTC equalled $1. If you’d put $5 in then, you’d be able to sell it for around $4500 right now (but I’d advise against it).
Remember the number of bitcoins that can exist, and the potential value question that I didn’t answer above? If bitcoins economy reaches even 1% the economy of the gold market (and hopefully I’ve argued enough that bitcoin is significantly more useful and valuable than gold), it would have a total market value of $90 thousand million USD, implying a value for each complete bitcoin of around $7.7 million USD. If you were to put $5 in right now, you’d get 0.0055BTC which would be worth $42350 then. My personal expectation for the long term (10 to 20 year) value of bitcoin however is far higher even than that. If I’m right, that could be the best $5 you ever made. If I’m wrong, you’ve lost $5.
My only strong advice would be to avoid the temptation to play it like a stock. You could make a lot of money that way, but you also could not only lose it all, but also lose any potential for the future. With the current volatility of bitcoin, it’s not uncommon for people to see it rising rapidly, expect that it’s on a meteoric rise, buy as much as they can, only to watch it crash down again. In their fear of losing it all, they sell for less than they bought to try to cut their losses, only to then see it rise up again some time later. If you’re going to try to play the trading game, buy after you’ve seen it crash, and sell once it’s risen well above where you bought it. It’s still really just gambling though, like any high volatility stock and the risks are too high to be something I’d ever seriously suggest.
In the price of bitcoin over the years, there have been a few small ‘bubbles’ and one very large one. The large one was caused mostly by market manipulation. In 2013, there was really only one popular bitcoin exchange online (there are now dozens) – MtGox. MtGox used automated systems (bots) to manipulate the market as well as flatly faking information on their site and lying to customers. With no competition, it was not obvious as it would be now and once bitcoin had reached an all-time high over well over $1200 USD per coin, they ceased trading, made various claims about the coins being ‘stolen’ by hackers and similar and then later filed for bankruptcy. The price of bitcoin plummeted to the low $100s. Legal proceedings took place, but the market took a long time to recover.
At the end of 2016, another small bubble hit. The crash at the start of 2017 is fresh in the memory of everyone following bitcoin and could even be said to be still underway, but any comparison to the events of 2013 only show how strong bitcoin has become since then. In mid-December 2016, 1BTC was around $770. By the new year, the price was around $1150. Only a few days later, it had fallen to $800 but now (2017-01-08) has risen again to around $900 and appears to be becoming moderately stable again.
The news media loves reporting ‘scary’ news though and the amount of “bitcoin crashes!” and “huge losses!” statements have scared many people away from bitcoin that haven’t had a more detailed and clear view of the value over time.
In fact, when looking at the value of bitcoin over time on a logarithmic scale (the only sensible way to view this kind of chart) rather than a linear scale, the bubbles are clearly visible, but so is the general upwards trend. This is the only logical view of the value of bitcoin if you’re treating it as a long-term investment rather than a day-trader’s stock.
So what does the future for bitcoin hold? No one can say for sure, but there are some interesting events and trends expected in 2017 that may have some influence.
The US Securities and Exchange Commission will decide in March whether to approve an ETF (Exchange Traded Fund) for Bitcoins set up by the Winklevoss Twins.
Also in March, an update to the Bitcoin Core software adding some minor features that will improve usability.
Sometime this coming year, it is likely that “SegWit” (Segregated Witness) will activate on the network. This protocol is added as a ‘soft fork’ and so requires consensus from the miners to activate. When it does, the bitcoin network will be able to handle a much larger volume of transactions without getting ‘clogged’.
Continuing instability or other problems in several major financial markets (e.g. Chinese Yuan, Euro, possibly UK Pound) as well as extreme problems in some minor ones (e.g. Venezuelan Bolivar, Mexican peso, many more).
At a bit over 5000 words, this article is long enough already, despite that I have much more that I could say on the topic. I would appreciate questions, comments and ideas from any and all.